Lumber Liquidators, Formaldehyde and you…

Lumber Liquidators (NYSE: LL) stock rebounded up today (March 10, 2015) nearly 6%. But over the course over the last couple weeks the stock has been hit by nearly a 60% loss after a profile on 60 Minutes which alleges Lumber Liquidators laminate products have unsafe levels of formaldehyde in them. Just about one year ago the stock was trading at around $108.00 per share. The stock was hammered after this report was just about to be released and hit again after it was made public. http://www.cbsnews.com/news/lumber-liquidators-linked-to-health-and-safety-violations/

Lumber Liquidators responded following the story basically saying that the testing methods used by the show are suspect and are a direct result of short sellers trying to manipulate the stock and that they stand behind their flooring. They promised a further response by March 12, 2015.

The California Air Resources Board (CARB) also updated their consumer information in response to the story:

The situation in one way is pretty clear. The short sellers of the stock are funding this investigation and it’s no surprise that the results support their short positions. There should be an investigation that confirms the testing methodology. Tests are a lot like statistics. They can be twisted to make almost any result plausible. Which calls back to the famous quote from Mark Twain: “There are three kinds of lies: lies, damned lies and statistics.” It is possible that tests were manipulated. Of course if the tests were complaint with the rigid standards which are clearly documented by the California Air Resources Board which is now the national standard then LL has a big problem and a potential nationwide recall on it’s hands.

Furthermore the report has hidden cameras that supposedly show the factories that are used by LL admitting the CARB information on the cartons and they allege what is represented to the customers by Lumber Liquidators on the cartons is a lie. Of course they did not really show the faces of the factory people for the most part when they were making these claims so it’s hard to say what actually was said or what context these allegations were made. The factory footage can be viewed as very damning based on how it was presented, but it is possible that they will be more clear UN-HIDDEN camera footage of those same people at the factories who tell a more complete story.

This blog has talked about the dangers of formaldehyde for a long time. And it is very common for Chinese factories to try and use cheaper core board material which has higher levels of formaldehyde as a method of cutting costs. There is no defense for any company who knowingly breaks the rules and endangers customers.

But let’s consider the source. The short sellers get to make HUGE profits by “exposing this scandal.” What if they manipulated 60 Minutes and Anderson Cooper into telling half truths? And CBS and 60 Minutes does not have a perfect record for representing the truth to begin with:

But, assuming the tests are accurate and properly done and do represent dangerous levels of formaldehyde the real question is did the company ask for that to reduce costs or did the supplier switch the material to lower their costs. This is a vital part of the equation. It doesn’t change the need to remedy the situation for consumers, but it does reflect about a company and it’s core values and it’s own future.

Traveling in China to source materials is something that anyone can do. And it is a common practice for the factories to tell you what works best for them. There is unlikely ever to been a situation where the factory says, “Hey – why not pay a little more and make sure you hit this particular safety standard?” In fact the idea that the factory will hold the buyer to rigid standards is laughable.

In almost every case the factory assumes the buyer wants the cheapest price and will be a proponent of getting to that cheaper price by using shoddy materials. The report from 60 minutes was not entirely in context. We don’t know what the conversation was before or after. We only know that the factory alleges LL materials do not meet Carb 2 standards. Without viewing the entire tape that shows the context of the conversation it is difficult to draw a conclusion with certainty.

If the factories really are shipping products that fail to meet the standards it is almost certain the LL will sue the factories and make claims against them for violating the written specifications which are part of the Lumber Liquidators purchasing process. Although getting recovery from Chinese firms may be difficult it is likely that LL requires the factories to carry product liability insurance. These policies are typically backed by North American or Global insurance carriers like CHUBB or AIG. These companies would have a significant potential loss on their hands if this is true.

If the factory can prove the Lumber Liquidators buyers are the one directing these changes to specifications and can illustrate that in writing they will not have any liability, but Lumber Liquidators will have a massive potential product recall problem. It is not without precedent for buyers who may be get bonuses based on sales and on margin to try and engineer a lower cost. There is also the possibility that the factory offered to grease a couple of the buyers or inspectors directly to turn their head when it came to the specs so that the factory could save the costs. Even if this is the case the company is still fundamentally responsible for the behavior of it’s buyers.

Perhaps the biggest issue here is that these types of stories are VERY SCARY to the average consumer. Another recent story in Canada that allege Lumber Liquidators is sourcing illegal timber and eliminating one of the last habitat’s for the Siberian tiger is devastating: http://globalnews.ca/news/1592177/russian-timber-thieves-selling-wood-in-north-america-environmentalist-says/

If this story is true is is absolutely disgusting. However, there should be a review of the facts to be sure that the story checks out.

Regardless of the specifics of each story consumers have the right to be concerned about these issues. The government in the US created laws to avoid these exact problems. The Lacey Act in the US is designed to prevent companies for importing illegal timber and to insure that they have a good chain of custody. Companies like Lowes, Home Depot and Lumber Liquidators are all responsible to comply with those laws. The problem is that some Chinese companies will fake the paper work. There are countless sources of illegal timber in China and those wood products often find their way to the USA despite the laws.

Chinese companies are also capable of faking CARB 2 paperwork or presenting a test from one batch of material and then subsequent production runs are switched to cheaper raw materials. Companies like Lumber Liquidators are responsible to be sure that their supply chain is meeting their specifications. The old saying is: “Trust, but verify.”

The purchasing paperwork from Lumber Liquidators will undoubtedly show that they required the factories to produce products according to the legal specifications. Unless the buyers left a paper trail giving the factories permission to alter the specifications the factories will have a lot to answer for. Of course they are largely out of reach of US consumers, but you can absolutely bet the scrutiny of those factories will be at an all time high for all companies that source in China.

Beyond making the specifications and getting initial testing companies must also verify and run random tests to measure each specification in future production runs to keep the factories on their toes. Without the threat of future random tests the factories have no incentive to stick to the specifications if the cost is higher to them. However, if the factory knows that the customer will not accept just one report in the beginning of the relationship, but instead will run random tests in the USA; they will generally comply with the requirements. It’s easier for them to just do it right than to get caught later. This is the part of the purchasing process that so many US companies do not get right. Most sourcing practices look for the supplier, get the initial paperwork done and then move onto the next deal. The ongoing verification is critical. It follows the same logic as the Broken windows theory: http://en.wikipedia.org/wiki/Broken_windows_theory

Too many times companies just assume the factories are in compliance when they are not.

From a big picture view it would be a mistake to take what 60 minutes says as pure fact. It would also be a mistake to assume the company’s position is proper without getting transparent answers.

Fundamentally the 60 Minutes story raised more questions than answers. It is now incumbent upon Lumber Liquidators to do their own investigation and come out with whatever the true story is – even if it hurts them. It is possible that 60 minutes was manipulated into doing the story by unethical short sellers and the future story is how 60 minutes got taken for the fool and how Lumber Liquidators seeks it’s restitution. If their results stand up Lumber Liquidators will have to focus on fixing the source of the issue and then resolving past problems. It will be messy and costly.

In the long run there should be little doubt that LL will survive this PR disaster even if the worst of the story proves true. In the short run there will be lots of pain for the company, it’s employees and it’s customers. In a year from now it seems very likely that the company will be almost fully recovered, the stock will trade north of $60 and perhaps a lot higher and this will be a bad memory. The company should be a better company as a result of this pain.

The other part of the story here is that Lumber Liquidators is not alone. There are countless US companies that important Laminate from China. There is no reason to assume that this formaldehyde situation, if it exists, is limited to one single company. The fact that 60 minutes claims it also tested some Chinese laminate from Lowes and Home Depot and those passed is not a full picture. Some companies intentionally break the rules to drab higher profits. This is essentially what 60 minutes is accusing Lumber Liquidators of. There are many companies in the USA and elsewhere that don’t always do the right thing. Canada the problem is far worse in terms of formaldehyde exposure. Canada does not have the CARB requirements and the factories are regularly using low grade core boards. Canada you need to protect your citizens by adopting similar standards to the US!

And finally in a bitterly ironic twist consumers should be aware that by pulling up their flooring they actually can cause more of a problem than by leaving the flooring intact as it was installed. The biggest problem with formaldehyde is when it is released into the air. Even if the results prove that the product has levels of formaldehyde that are too high, which is still up for debate, the PROPER way to remove it is the immediate next point of discussion. When consumers chop up their flooring and cut it up into little pieces all of the the core material that is cut or disturbed can go airborne. All of that dust is a potential carcinogen. 60 Minutes should have warned customers that before they panic and simply start sawing into their floor they should consult with a specialist about how to deal with the problem. This is similar to asbestos abatement concepts. When the asbestos was used in flooring in the 50’s (called VCT) the problem was encapsulated and not a major health concern as long as it remained intact. However, if the VCT was removed that is when the problem could go airborne and create substantial health risks. If CBS was interested in helping customers as opposed to using scare tactics they should have warned customers that they could actually make the problem worse by tearing it out without following good procedures to avoid exposure to the airborne contaminants.

There are plenty of good companies in the USA that do the right thing. There are lots of good factories in China too. There are good people who do the right thing at both the factories and domestic companies. The tricky part for the consumer is finding someone you can trust that will guide you through the floor buying process and not leave your house with cancer causing chemical emissions.

The opinions herein are our own opinions. We have no stock or positions in Lumber Liquidators.